13 October 2020
Pension scheme trustees don’t usually make investment decisions based on the impact on corporate accounting. This blog examines what corporate sponsors need to look out for so they can potentially influence those investment decisions accordingly.
Hedging your bets
Excessive hedging levels can weaken corporate balance sheets if interest rates rise.
Accounting liabilities are usually based on “best estimate” assumptions with the liability cashflows typically lower than for the funding liabilities. This can lead to an “over-hedging” of interest rates on the accounting measure –meaning that when interest rates rise the asset value reduces more than the corresponding fall in the accounting liability. In general this balance sheet deterioration is only likely to get worse over time, as funding liabilities are expected to approach a higher long-term funding target.
The extent to which this is offset, if at all, by any “natural hedging” within the business more widely will be one of several factors affecting the sponsor’s attitude to this risk.
High inflation hedging levels cause a similar challenge, but the impact is often more severe because a lower inflation assumption is often used for accounting compared to funding.
Trustees generally don’t assess the hedge ratios against the sponsor’s accounting measure, meaning this effect can often go unnoticed until it’s too late. The most appropriate action to address this will depend on many factors, but at the very least the sponsor should consider these effects as part of the investment strategy consultation discussions.
The right kind of credit
All else equal, investment grade corporate bonds are attractive to sponsors as they offer some balance sheet protection against falling credit spreads and a high degree of security due to the low chance of default.
A higher allocation to corporate bonds can also enhance the stability of P&L.
Insurance “buy-ins” usually result in a weaker balance sheet as the IAS19 asset value of the insurance policy is typically lower than the premium paid (there may be more flexibility here under US GAAP than IAS19).
For many, this can be a good trade-off given the risk reduction. However, for balance-sheet focussed corporates it may be more palatable to reduce risk in other ways such as LDI and longevity hedging.
Asset performance, volatility and diversification
Good asset performance improves both the corporate’s and the scheme’s balance sheet.
However, if the corporate is sensitive to balance sheet volatility, for example where the scheme is very large compared to the corporate, then lower volatility strategies should be considered. Higher levels of diversification or explicit equity protection strategies could help in this regard.
Under US GAAP, expected return on assets can play a big role. All else equal, higher expected returns lead to better P&L (albeit for some, recent US GAAP changes mean this is no longer an Operating credit). It’s therefore important for sponsors reporting under US GAAP to consider the expected returns when consulting with their trustees on investment strategy and how best to reflect these within the accounting assumptions (noting there’s no single right answer and a range of acceptable assumptions). These could include dynamic LDI outperformance assumptions, and bespoking credit premium assumptions to more correctly reflect the underlying credit rating/risk profile of the investments held.
There is a lot to think about when it comes to these accounting issues, but keeping your eyes trained on these issues will ultimately help reduce the risks of your pension scheme damaging your profits or balance sheet, which is likely to be all the more important given the current economic headwinds.